S&P parent expects to beat gov’t ratings lawsuit

Standard & Poor’s is prepared to spend years beating back a federal lawsuit that accuses the company of giving falsely high ratings to mortgage investments that helped trigger the financial crisis, executives said Tuesday.

“Rest assured, we will vigorously defend against these erroneous claims,” said Harold McGraw III, president and CEO of The McGraw-Hill Cos., which owns S&P, on a call with analysts.

The government may seek up to $5 billion — several years’ worth of profits for McGraw-Hill, it said in a civil complaint filed in Los Angeles federal court last week. The company believes the charges lack merit, but the case is likely to drag on for three or more years, general counsel Ken Vittor said on the call.

The call was scheduled in connection with McGraw-Hill’s fourth-quarter earnings report, but executives spent much of it refuting the government’s allegations. CEO McGraw and the company’s top financial executive shortened their remarks to leave time for the legal discussion.

McGraw-Hill swung to a loss in the three months ended Dec. 31 as its transition to a financial information provider forced it to take a big, one-time charge. Excluding one-time items, the company’s net income declined but narrowly beat Wall Street’s forecasts.

Despite what McGraw called “an outstanding year,” analysts on the call focused on the company’s ability to fend off the lawsuit and maintain growth in the Standard & Poor’s Rating Services division.

Executives said they expect the credit rating business to keep growing despite the new scrutiny. Low interest rates are making it easier for companies to issue bonds. Demand for ratings is spiking from emerging markets like India, they said.

Standard & Poor’s Ratings is crucial to McGraw-Hill’s bottom line. The rating business contributed 70 percent of McGraw-Hill’s operating profit and 46 percent of its revenue from continuing operations in 2012. The company is shedding non-financial businesses like its textbook publisher.

The Justice Department accused S&P of knowingly inflating its ratings because it wanted to earn more business from its clients — the banks whose investments it was hired to rate.

According to the lawsuit, S&P recognized in 2006 that home prices were sinking and that borrowers were having trouble repaying loans. Yet these facts weren’t reflected in the safe ratings S&P gave to complex real-estate investments known as mortgage-backed securities and collateralized debt obligations, the lawsuit alleges.

High ratings from the three agencies made it possible for banks to sell trillions in risky investments. Some investors, including pension funds, can buy only securities that carry high credit ratings.

The charges are the Obama administration’s most aggressive action to date against those deemed responsible for contributing to the worst financial crisis since the Great Depression. They follow years of criticism that the government had failed to do enough.

Vittor, the general counsel, cast doubt Tuesday on the government’s ability to prove its case. Responding to a question about why S&P was singled out among the big three rating agencies, he said, “For us, the question is less the ‘why’ than the ‘how’: How will the Department of Justice prove a fraud claim against S&P’s analysts for arriving at ratings through a committee process that are identical to the ratings issued independently by other rating agencies?”

It is not clear why the government charged only S&P, or whether it will file charges against Fitch and Moody’s, S&P’s two main rivals.

Responding to the charges Tuesday, executives noted that they have successfully defended against 40 other financial crisis-related lawsuits. They said they are open to “discussing reasonable settlements” to end this or any other lawsuit.

S&P declined to say how much the case is costing. Chief Financial Officer Jack Callahan said “it’s not an insignificant item in our income statement right now.” He said the company understands the cost may increase in 2013. That expectation is reflected in its earnings guidance.

The company introduced 2013 revenue guidance of “high single-digit growth,” suggesting that revenue this year could fall between $4.76 billion and $4.85 billion. It expects adjusted earnings per share this year of $3.10 to $3.20.

The McGraw-Hill Cos., based in New York, lost $216 million, or 76 cents per share, in the three months ended Dec. 31. That compares with net income of $214 million, or 73 cents per share, a year earlier.

The loss was driven by a $497 million charge McGraw-Hill took on the pending sale of its education division. McGraw-Hill said in November that it will sell the textbook and e-learning publisher for $2.5 billion in cash and debt. As part of the deal, McGraw-Hill will be renamed McGraw Hill Financial.